Protective Put

An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a “protective put.”

Market Outlook

Bullish sentiment among market participants on the underlying security.

When to Use

The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, and generally has unrealized profits accrued from an increase in value of those shares. He might have concerns about unknown, downside market risks in the near term and wants some protection for the gains in share value. Purchasing puts while holding shares of underlying stock is a directional strategy, but a bullish one.

Profit & Loss Chart

Benefit

Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put serves to limit downside loss in unrealized gains accrued since the underlying stock’s purchase. No matter how much the underlying stock decreases in value during the option’s lifetime, the put guarantees the investor the right to sell his shares at the put’s strike price until the option expires. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when he chooses to sell his stock.

Risk & Reward

Maximum Profit: Unlimited
Maximum Loss: Limited

Upside Profit at Expiration: Gains in Underlying Share Value Since Purchase – Premium Paid

Potential maximum profit for this strategy depends only on the potential price increase of the underlying security; in theory it is unlimited. If the put expires in-the-money, any gains realized from in an increase in its value will offset any decline in the unrealized profits from the underlying shares. On the other hand, if the put expires at- or out-of-the-money the investor will lose the entire premium paid for the put.

Break Even Point

Stock Purchase Price + Premium Paid

Volatility Changes

Increase In Volatility: Positive Effect
Decrease In Volatility: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay (Theta)

Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.